Labor Dept. backs off on ESG rule -- slightly

The revised order removes references to ESG but still sticks to its requirement that retirement managers only focus on risk and return

By Anthony B. Davidow

(About the author: Tony Davidow is president and founder of T. Davidow Consulting, an independent advisory firm focused on the challenges facing the financial services industry. His focus is on helping advisers and investors incorporate complex strategies in their portfolios.)

WILTON, CONN. (Callaway Climate Insights) — The Department of Labor issued the final rule regarding the screening of ESG factors in retirement plans on Friday. After the initial rule was widely criticized, the DOL softened its rhetoric slightly, and extended the time to implement the new standards to April 2022. As I have previously written, the proposed rule was designed to limit, or eliminate, ESG funds in retirement plans based on the premise that it would harm retirees. In fact, much of the data has shown that ESG funds have outperformed the market while taking on less risk.

While the rule does not specifically reference the term ESG, it addresses President Trump’s executive order earlier this year asking the DOL to review retirement plans that excluded the energy sector. The new rule amends the DOL’s investment duties regulation of 1979 directing fiduciaries to only make recommendations based on risk and/or return of an investment on a portfolio.     

This politically motivated rule received a harsh rebuke from the public, with 96% of the respondents to the initial proposal opposing the rule; 85 out of 86 asset managers and 44 out of 46 financial advisers viewed the proposed rule as being overly restrictive. 

Perhaps the strongest rebuke came from Morningstar. Morningstar is uniquely positioned to respond to this issue as they have a history of tracking and rating ESG funds, and through their Sustainalytics subsidiary, they provide ESG ratings and data on individual companies. 

The DOL rule assumes that investors would be harmed by putting their values ahead of the results; but in fact, the data has consistently shown that investors can do good and do well.

Morningstar, in its July 30 comment on the proposed rule, said:

“Indeed, ESG-focused funds have generally outperformed conventional fund peers over the past one-, three-, and five-year periods according to Morningstar research. That does not mean that every sustainable fund outperformed, but sustainable large-blend funds have outperformed the S&P 500 net of fees in the past half-decade. Sustainable funds are also more likely to be in the top quartile of performers than conventional funds over these periods.”  

The DOL has taken a surprisingly forward-looking view in considering private equity in retirement plans. Secretary of Labor Eugene Scalia said in a DOL news release on the ruling that allowing 401(k) participants to invest in private equity “will help Americans saving for retirement gain access to alternative investments that often provide strong returns.”

While I applaud the DOL’s position regarding private equity, one has to wonder why they have taken such a naïve stance regarding ESG. Based on the historical results, shouldn’t the DOL adopt a similar approach to allowing, and even encouraging ESG in retirement plans? Does the DOL really think that ESG funds are riskier than private equity?  

Clearly, this decision to limit ESG was politically motivated and not based on the underlying data. Hopefully, fiduciaries will consider ESG funds in 401k plans and target funds; and allow investors to align their values and portfolios. The next Administration may choose to revisit this rule, and may in fact encourage the inclusion of ESG options in retirement plans.